Article: Credit markets face high price for sleight of hand


From the December 11 2007, Financial Times:

Insight: Credit markets face high price for sleight of hand
By Satyajit Das, risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives

Banks have been indulging in their version of the shell game – and this sleight of hand will have long-lasting implications for the credit markets.

To recap: the game requires three shells, under one of which is placed a small pea. The shells are shuffled around and bets are taken on the location of the pea.

“Risk transfer” is the shell game of the credit markets.

Regulators believe erroneously that if credit risk is distributed widely it reduces the chance of a crash. Risk transfer does not decrease risk but increases it in complex ways.

Banks originate loans that are securitised. Alchemy is used to convert risky debt, with the help of rating agencies, into AAA/AA asset-backed securities. The ABS is then sold to conduits that issue highly rated ABS-backed commercial paper to investors.

Alternatively, the high-quality ABS is sold to structured investment vehicles which then issue AAA-rated debt to fund the purchase. SIVs even purchase highly rated debt from other SIVs in an astonishing chain of risk. High-quality ABSs are sold to hedge funds that leverage the AAA-rated assets (up to 20-30 times) via banks willing to lend against the value of the securities. Debt seems to buy more debt in a spiral of borrowing. At each level, banks charge fees and earn margins from money they lend.

Risk transfer encourages declines in credit standards as the banks do not intend to hold the risk. The bank receives the difference between the interest on the loan and the return demanded by the investor “up front”. As loans are sold off, ever larger volumes are necessary to maintain profitability.

The growth in the subprime market resulted from the necessity for banks to seek out new markets to generate volumes to fuel their high fixed-cost securitisation platforms.

Banks frequently don’t actually sell off their real risks. They sell off less risky loans. In a collateralised debt obligation, the bank typically takes all or a portion of the riskiest securities – the equity tranche. This is “hurt money” or the “skin in the game” to reassure other investors. Banks must hold the loans until they can be sold. In a market disruption, if the bank is unable to sell then the risk remains with the bank.

But risk also returns to the bank via the back door. Where it acts as a prime broker – executing trades, settling transactions and financing hedge funds – the bank lends to investors using CDO securities as collateral.

The bank assumes risk to the value of the collateral. Banks provide liquidity – standby lines of credit – to the conduit vehicles to cover funding shortfalls. If commercial paper cannot be issued, then the banks end up holding the assets that they have supposedly sold off.

Risk transfer assumes that the risk is transferred to adequately capitalised investors. About 60 per cent of credit risk in recent years was transferred to leveraged hedge funds.

In modern credit markets, about one dollar of “real” capital might support between $20 and $30 of loans. Banks must hold $1 of capital against $12.50 of loans.

The higher leverage can only be sustained in a very low default rate environment. Credit risk also moves from a place where it was regulated and observable to a place where it is less regulated and more difficult to identify.

Thus, “transferred” credit risk is now finding its way back on to bank balance sheets as off-balance sheet structures and hedge funds are forced to sell. The total amount that will be re-intermediated by banks is unknown – probably, in the range of $1,000bn to $2,000bn.

The financial shell games that banks, with the tacit support of regulators, have played mean that credit markets are likely to remain sclerotic for years. Banks will reduce lending and need to raise new capital urgently to support the returning assets. As the risk transfer business winds down, the outlook for earnings from this activity will be reduced. Regulations for “risk transfer”, that allowed this to happen, also need urgent reform.

There is a need for real rather than “false” risk transfer.


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